What is opportunity cost?

What is opportunity cost?

Opportunity cost is the estimated return of investments you don't make compared to the expected return of investments you do make. It's an important factor to consider when allocating time or resources to any type of project (essentially, "would my time or money be better spent elsewhere?").

Why is opportunity cost important?

Opportunity cost is one of the first terms that is introduced to students of economics, but it's not always well-known outside of those circles. For ecommerce merchants, who come from a variety of backgrounds and have different sets of skills and experiences, the concept may be totally unknown.

There's good news, though. The principles behind opportunity cost are being applied in some fashion by many store owners, even if they've never heard of the term itself. In the long view, understanding opportunity cost is an important part of making smart business decisions. Here's a look at the technical and practical definitions of the term, as well as how it applies specifically to ecommerce and the people who run online stores.

The technical definition

One textbook definition of opportunity cost is provided by the Merriam-Webster dictionary, which says the term refers to "the added cost of using resources (as for production or speculative investment) that is the difference between the actual value resulting from such use and that of an alternative (as another use of the same resources or an investment of equal risk but greater return)" (1). In abstract, technical terms, this is a strong definition - but it means little to those who aren't students of economics or consistently involved in a related field.

A more approachable definition is to call opportunity cost the difference between a chosen action, such as a purchase or investment, and the other seemingly viable opportunities that are also available. The cost in this case is the lost potential for a positive outcome, which is discarded or lost because the decision-maker has chosen a different purchase, strategy or other economic decision because there are only limited economic resources available.

Examples

A concrete example of opportunity cost can make the idea easier to understand. Consider the owner of a building who decides that her vacant first-floor space will become a restaurant. The opportunity cost of making such a decision is that the space can no longer be used for a different purpose, such as a retail store or an office space that's rented to another party.

Another example uses a farmer to display the same concept. Once a farmer chooses a crop - for example's sake, cucumbers - the limited resource of available land can no longer be used to grow another crop, such as potatoes or carrots (2). The opportunity cost of growing cucumbers on a finite piece of farming land is that other crops can't be grown at the same time.

Opportunity cost is tied to the concept of risk, and can be viewed through that lens. Opportunity cost is, in many ways, another way of describing the relative risks of choosing one option over another. The risk of one option providing a better or worse return than another is at the heart of the concept.

One important part of the overall concept to note is that opportunity cost may end up being positive or negative. In the example above, the farmer may have made the right decision, making more money by selling and otherwise using his cucumber crop than he would have with the potatoes or carrots. The converse is also true. Various market factors during the course of the growing season could make potatoes especially valuable and bring cucumbers below their normal price.

The other crucial component of opportunity cost is that it doesn't only apply to financial concerns. While money is often the thing in mind when the various options are considered, other resources such as time and labor can be involved as well. For example, the financial cost of the farmer planting two different crops may be the same, but one could involve significantly more labor in terms of planting or harvesting. The opportunity cost of the more labor-intensive crop is more time spent working in the field, as opposed to the other option.

The practical applications

Opportunity cost is a useful and proven method for considering different business decisions before they happen. While no one has perfect knowledge of what will happen in the future, weighing the expected results of a variety of options and considering both the positives and negatives is a responsible approach to decision-making. Because every commercial entity and enterprise, from first-time owners of ecommerce stores to the world's largest businesses, has a limited amount of resources, the concept of opportunity cost is an important one.

How opportunity costs specifically apply to ecommerce merchants

The examples above make sense for farmers and property owners, but how do they intersect with the world of ecommerce? The reality is that opportunity cost can be applied to nearly all areas of operating an online store that involve the use of resources and more than one seemingly suitable option.

The most obvious application of opportunity cost comes in stocking inventory. Not only do ecommerce entrepreneurs have a limited amount of money with which they can purchase inventory, they also have a limited amount of space. In this situation, opportunity cost can be determined on both the different types of merchandise that may be bought and the amount of space they take up in storage. Considering these variables, and the potential results of choosing one over the other, helps to paint a clear picture of the different options available. For merchants who make the products they sell online, the opportunity costs of different raw materials can be considered in much the same fashion.

Opportunity costs certainly apply in other areas of ecommerce as well. Shipping items out to customers is just one example. The opportunity costs of offering a wide variety of shipping options - incurring more of a price tag but also potentially boosting customer satisfaction - can be weighed against a simpler approach that involves less time, effort and money but may be less effective. The addition of new product lines, the hiring of additional employees, or the expansion from one's home into a commercial business space, are just two of the many other potential applications.

In conclusion

Opportunity cost is a very abstract concept in its technical definition, but it has many practical applications for ecommerce store owners. Using the opportunity cost approach can help merchants weigh the pros and cons of different decisions, finding the path that they feel is most effective or comfortable.